MINI CASE

You have just been hired as a financial analyst by Harry Davis Industries,
Inc. Your first assignment is to estimate the firm's cost of capital. To get
you started, the CFO assembled the following information:
(1) The firm's federal-plus-state tax rate is 40 percent.
(2) The firm has outstanding an issue of 10 percent, semiannual coupon,
noncallable bonds with 15 years remaining to maturity. They sell at a
price of $1,081.44. The firm does not use short-term debt on a permanent
basis.
(3) The current price of the firm's perpetual preferred stock (9 percent,
$100 par value, quarterly payment) is $115.00. New perpetual preferred
could be sold to the public at this price, but Davis would incur
flotation costs of $2.50 per share.
(4) The firm's common stock is currently selling at $76 per share. Its last
dividend (D0) was $5.00, and investors expect the dividend to grow at a
constant 6 percent rate into the foreseeable future. The firm's beta is
1.25; the current yield on T-bonds is 7 percent; and the market risk
premium is estimated to be 5 percent. When using the bond-yield-plus-
risk-premium approach, the managers assume a risk premium of 4 percentage
points.
(5) New common stock would involve flotation costs, including market
pressure, of 10 percent.
(6) The firm's target capital structure is 30 percent long-term debt, 10
percent preferred stock, and 60 percent common equity.
(7) The company forecasts retained earnings of $300,000 for the coming year.
(8) Depreciation expenses for the coming year are expected to be $500,000.
To structure the task a bit, the CFO asked you to answer the following
questions:
a. (1) What sources of capital should be included in the estimate of
Davis's WACC?

ANSWER: The WACC is used primarily for making long-term capital investment
decisions, that is, for capital budgeting purposes. Thus, the WACC should
include the types of capital used to pay for long-term assets, and this is
typically long-term debt, preferred stock (if used), and common stock.
Short-term sources of capital consist of (1) spontaneous, noninterest-bearing
liabilities such as accounts payable and accruals and (2) short-term
interest-bearing debt, such as notes payable. If the firm uses short-term
interest-bearing debt to acquire fixed assets rather than just to finance
working capital needs, then the WACC should include a short-term debt
component. Noninterest-bearing debt is generally not included in the cost of
capital estimate because these funds are netted out when determining
investment needs; that is, current asset requirements are offset by increases
in spontaneous current liabilities.

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 13
a. (2) Should the component cost estimates be on a before-tax or an after-
tax basis?

ANSWER: Stockholders are concerned primarily with those corporate cash flows
that are available for their use, namely, those cash flows available to pay
dividends or for reinvestment. Since dividends are paid from and reinvestment
is made with after-tax dollars, all cash flow and rate of return calculations
should be done on an after-tax basis. (Note: This explanation is a
simplistic one, yet probably sufficient for the first course. The correct
answer is that the tax benefits of debt financing will not be incorporated
into the cash flows, so the tax deductibility of debt must be incorporated in
the WACC.)

a. (3) Should the cost estimates reflect historical (embedded) costs or

new (marginal) costs?

ANSWER: In financial management, the cost of capital is used primarily to make

decisions which involve raising new capital. Thus, the relevant component
costs are today's marginal costs rather than historical costs.

b. (1) What is the firm's component cost of debt?

ANSWER: The firm's 10 percent semiannual coupon bond with 15 years to maturity
is currently selling for $1,081.44. Thus, its yield to maturity is 9 percent:

0 1 2 3 29 30
||
-1,081.44 50 50 50 50 50
1,000

Enter N = 30, PV = -1,081.44, PMT = 50, and FV = 1,000, and then press the I
button to find I = 4.5%. Since this a semiannual rate, multiply by 2.0 to
find the annual rate, kd = 9%, the pre-tax cost of debt.
Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost,
and the company's relevant component cost of debt is the after-tax cost:

kd (1 - T) = 9.%(1 - 0.40) = 9.0%(0.60) = 5.4%. 0

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SOLUTION TO MINI CASE
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Chapter 6 - 14 Copyright © 1996 by The Dryden Press. All rights reserved.
b. (2) Should flotation costs be considered?

ANSWER: The actual component cost of new debt will be somewhat higher than 5.4
percent because the firm will incur flotation costs in selling the new issue.
However, flotation costs are typically small on public debt issues, and, more
important, most debt is placed directly with banks, insurance companies, and
the like, and in this case flotation costs are almost nonexistent.

b. (3) Should you use the nominal cost of debt or the effective annual
cost?

ANSWER: Our 9 percent pre-tax estimate is the nominal cost of debt. Since the
firm's debt has semiannual coupons, its effective annual cost rate is 9.20
percent:
(1.045)2 - 1.0 = 1.0920 - 1.0 = 0.0920 = 9.20%.
However, nominal rates are generally used. The reason is that the cost of
capital is used in capital budgeting, and capital budgeting cash flows are
generally assumed to occur at year-end, which undervalues the flows since they
actually occur all throughout the year. Since the nominal rate underestimates
the cost of debt, using nominal cost rates makes the treatment of the capital
budgeting discount rate and cash flows consistent.

b. (4) Would a cost of debt estimate based on 15-year bonds be a valid

estimate of kd if the firm actually planned to issue 30-year bonds?

ANSWER: The yield-to-maturity on a 15-year bond would only be a true estimate

of the cost of 30-year bonds if the yield curve were flat. Again, however,
the differences are typically small over that maturity range; hence, yield
curve adjustments are seldom made.

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 15
c. (1) What is the firm's cost of preferred stock?
ANSWER: Since the preferred issue is perpetual, its cost is estimated as
follows:

Dps 0.09($100) $9
k ps = = = = 0.080 = 8.0%. 0
Pn $115.00 - $2.50 $112.50

Note (1) that flotation costs for preferred are significant, so they are
included here; (2) that since preferred dividends are not deductible to the
issuer, there is no need for a tax adjustment; and (3) that we could have
estimated the effective annual cost of the preferred, but as in the case of
debt, the nominal cost is generally used.

c. (2) Is the firm's preferred stock more or less risky to investors than
its debt? Why is the yield to investors on the preferred lower than
the yield to maturity on the debt?

ANSWER: Preferred stock is more risky than debt, since the company does not
have a contractual obligation to pay preferred dividends--they are declared
each quarter by the firm's board of directors. However, firms have every
intention of meeting their preferred dividend payments, because if they fail
to do so (1) they cannot pay dividends on their common stock, (2) they will
find it very difficult to raise additional funds in the capital market, and
(3) in some cases preferred stockholders have the right to assume control of
the firm.
Corporate investors own most preferred stock, because 70 percent of
preferred dividends received by corporations are nontaxable. Therefore,
preferred often has a lower before-tax yield than the before-tax yield on debt
issued by the same company. Note, though, that the after-tax yield to a
corporate investor, and the after-tax cost to the issuer, are higher on
preferred stock than on debt. This corresponds with the higher risk of
preferred stock.

c. (3) Now suppose you discovered that the firm's preferred stock had a
mandatory redemption provision which specified that the firm must
redeem the issue in five years at a price of $110 per share. What
would the firm's cost of preferred be in this situation? (Ignore
this part in the remainder of the case.)

ANSWER: If the firm had a maturity date (or sinking fund), then its cash flow
would be like those of a bond and should be evaluated using bond valuation
techniques.
In this situation, the time line looks like this:

0 1 2 3 4 5

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SOLUTION TO MINI CASE
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Chapter 6 - 16 Copyright © 1996 by The Dryden Press. All rights reserved.
 -115.00 9 9 9 9 9
110
Enter N = 5, PV = -115.00, PMT = 9, and FV = 110, and then press the I button
to find I = 7.07%. This is the preferred's pre-tax yield to investors. To
find the company's component cost of capital, flotation costs would have to be
taken into account by using $112.50 as the cash flow in year 0, which would
produce a cost of 7.62%.

d. (1) Why is there a cost associated with retained earnings?

ANSWER: The company's earnings can either be retained and reinvested in the
business or paid out as dividends. If earnings are retained, the firm's
shareholders forego the opportunity to receive cash and to reinvest it in
stocks, bonds, real estate, and the like. Thus, Davis should earn on its
retained earnings at least as much as its stockholders themselves could earn
on alternative investments of equivalent risk, such as buying more of Davis's
stock. Further, the company could always repurchase its own stock and earn a
return of ks. We conclude that retained earnings have an opportunity cost
that is equal to ks, the rate of return investors expect on the firm's common
stock.

d. (2) What is the firm's estimated cost of retained earnings based on the
CAPM approach?

ANSWER: The CAPM estimate for the firm's cost of retained earnings is 13.25
percent:
ks = kRF + (kM - kRF)b = 7.0% + (5.0%)1.25 = 7.0% + 6.25% = 13.25%.

d. (3) Why is the T-bond rate a better estimate of the risk-free rate than
is the T-bill rate?

ANSWER: The T-bond rate is the best proxy for the risk-free rate when using
the CAPM because (1) it embodies long-term inflation expectations, (2) it is
influenced less by Federal Reserve actions, international currency flows, and
the like, and (3) T-bonds are a more logical investment alternative to stocks
than are T-bills.

d. (4) What is the difference among historical betas, adjusted betas, and
fundamental betas?

ANSWER: An historical beta is found by simply running a linear regression

between past returns on the stock and past returns on a market index.
Adjusted betas are historical betas which have been adjusted to reflect the
tendency of betas to move towards 1.0 over time. Fundamental betas are
further adjusted to include changes in a company's fundamental factors such as
leverage, sales volatility, and the like. Both adjusted and fundamental betas

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 17
attempt to overcome the fact that historical betas measure past market risk,
while investors are primarily interested in future market risk.

d. (5) Describe two methods which can be used to estimate the market risk
premium.

ANSWER: Market risk premiums can be estimated using either historical data or
future estimates. Historically, Ibbotson Associates have found that the
return premium of stocks over T-bonds has averaged about 7.2 percent from 1926
through 1993. Alternatively, one can use current estimates of the expected
market return provided by financial services companies such as Merrill Lynch,
and then subtract the current T-bond rate to estimate the market risk premium.
We lean toward the ex-ante risk premium, in part because the long period of
rising (and unanticipated) inflation that occurred over the 1926-1993 period
has depressed bonds' realized returns and thus raised the historical market
risk premium.

e. (1) What is the estimate of the firm's discounted cash flow (DCF) cost
of retained earnings, ks?

ANSWER: Since Davis is a constant growth stock, the constant growth model can
be used:

D1 + g = D0 (1 + g) + g = $5.00(1.06) + 0.06
ks = k̂s =
P0 P0 $76 0
= 0.07 + 0.06 = 7.0% + 6.0% = 13.0%.

e. (2) Suppose the firm has historically earned 15.5 percent on equity
(ROE) and retained 40 percent of earnings, and investors expect this
situation to continue in the future. How could you use this
information to estimate the future dividend growth rate, and what
growth rate would you get? Is this growth rate consistent with the
6 percent given earlier?

ANSWER: The retention growth formula is g = b(r), where b is the expected

future retention rate, and r is the expected return on equity. If Davis's
historical figures are expected to continue into the future, then the
retention rate is 40 percent and its expected return on equity is 15.5
percent. The growth rate estimate is calculated as follows:
g = 0.40 (15.5%) = 6.20%.
This compares reasonably well with the 6 percent growth rate we have used.

e. (3) Could DCF methodology be applied if the growth rate was not

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SOLUTION TO MINI CASE
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Chapter 6 - 18 Copyright © 1996 by The Dryden Press. All rights reserved.
 constant? How?

ANSWER: In general, a nonconstant growth stock is expected to reach an

economy-wide constant growth rate at some point in the future, say 5 or 10
years hence. With this in mind, we can use two approaches to find the
expected cost of equity for nonconstant growth rates with the DCF model. The
first is to use the nonconstant growth stock model developed in Chapter 4 to
find the expected rate of return. This is not conceptually difficult, but it
does require a trial-and-error process.
As an alternative, a nonconstant growth forecast can be used to develop
a proxy constant growth rate. The present value of dividends beyond year 50
is practically zero so we can ignore these cash flows. If we consider only a
50-year horizon, we can develop a single weighted average growth rate from the
nonconstant and constant growth rate components, and then use it in the
constant growth rate model.

f. What is the firm's cost of retained earnings based on the bond-yield-

plus-risk-premium method?

ANSWER: The bond-yield-plus-risk-premium estimate is 13 percent:

ks = Bond yield + Risk premium = 9.0% + 4.0% = 13.0%.
Note that the risk premium required in this method is not the CAPM risk
premium, and it is difficult to estimate, so this approach only provides a
ballpark estimate of ks. It is useful, though, as a check on the DCF and CAPM
estimates, which can, under certain circumstances, produce unreasonable
estimates.

g. What is your final estimate for ks?

ANSWER: The following table summarizes the ks estimates:
Method Estimate
CAPM 13.25%
DCF 13.00
kd + RP 13.00
Average 13.10%
At this point, considerable judgment is required. If a method is deemed to be
inferior due to the "quality" of its inputs, or if it produces nonsensical
results like a ks estimate that is less than the kd estimate, then it might be
given little weight or even disregarded. In our example, though, the three
methods produced relatively close results, so we decided to use the average,
13.1 percent, as our estimate for the firm's cost of retained earnings.

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 19
h. (1) What is the firm's cost of new common stock, ke?
ANSWER: The DCF method produced an estimate for the cost of retained earnings
of ks = 13.0%:

D0 (1 + g) + g = $5.00(1.06) + 6.0% = 7.0% + 6.0% = 13.0%. 0

ks = k̂s =
P0 $76

However, flotation costs of F = 10% must be incurred when new common stock is
sold, and that increases the DCF cost of equity to 13.75%:
D0 (1 + g) + g = $5.00(1.06) + 6.0% = 7.75% + 6.0% = 13.75%. 0
k e = k̂e =
P0 (1 - F) $76(1 - 0.10)
Thus, flotation costs increase the cost of equity by 75 basis points:
Flotation adjustment = 13.75% - 13.0% = 0.75%.
We can add the 75 basis points flotation adjustment to the average of the
three common equity costs, ks = 13.1%, to find ke for new issues of common
stock:
Flotation 13.85% for new issues
k e = ks + = 13.1% + 0.75% = .0
adjustment of common stock

h. (2) Explain in words why new common stock has a higher percentage cost
than retained earnings.

ANSWER: The company is raising money in order to make an investment. The

money has a cost, with the cost based primarily on the investors' required
rate of return, given risk and other investment opportunities. So, the new
investment must provide a return at least equal to the investors' cost.
If the company raises capital by selling stock, the company doesn't get
all of the money raised. For example, if investors put up $100,000, and if
they expect a 10% return, then $10,000 of profits must be generated. But if
flotation costs are 20% ($20,000), then the company will net only $80,000.
That $80,000 will have to produce a $10,000 profit, or a $10/$80 = 12.5% rate
of return versus 10% for equity raised as retained earnings.

I. (1) What is the firm's overall, or weighted average, cost of capital

(WACC) when only retained earnings are used as the equity component?

ANSWER: The firm's WACC is 10.3 percent when retained earnings are used as the
equity component (at 13.1%), calculated as follows:

WACC1 = wd k d (1 - T) + wps k ps + wce ks

= 0.3(9%)(0.6) + 0.1(8%) + 0.6(13.1%) 0
= 1.6% + 0.8% + 7.9% = 10.3%.

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SOLUTION TO MINI CASE
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Chapter 6 - 20 Copyright © 1996 by The Dryden Press. All rights reserved.
I. (2) What is the WACC when new common stock is used as the equity
component?

ANSWER: When new common stock is sold, the WACC increases from 10.3 percent to
WACC2 = 10.7 percent:

WACC2 = 0.3(9%)(0.6) + 0.1(8%) + 0.6(13.85%)

0
= 1.6% + 0.8% + 8.3% = 10.7%.

j. (1) At what amount of new investment would the firm be forced to issue
new common stock? (For now, ignore the depreciation cash flow.)

ANSWER: The dollar amount of total new capital at which Davis uses up its
retained earnings and must resort to selling new common stock is called the
retained earnings break point:

Dollars of retained earnings $300,000

BPRE = = = $500,000. 0
Target proportion of equity 0.60

In raising $500,000 of new capital, Davis would finance as follows:

0.3($500,000) = $150,000 of Debt
0.1($500,000) = 50,000 of Preferred
0.6($500,000) = 300,000 of Retained earnings
$500,000 Total

If the firm required an additional $1 of new capital, this $1 would be raised

by selling $0.30 of debt, $0.10 of preferred, and $0.60 of new common stock,
because the $300,000 of retained earnings would have already been used up.
Note that, in reality, the firm might finance using primarily debt in one
year, primarily preferred the next, and primarily equity in the third, but,
over the long haul, Davis would finance in accordance with its target capital
structure, so the target weights should be used regardless of the actual
financing in any one year.

j. (2) Construct the firm's MCC schedule. Is it reasonable to assume that

the firm's MCC schedule would remain constant beyond the retained
earnings break point regardless of the amount of capital required?
Would what the company planned to do with the money it raised have
any effect on the WACC?

ANSWER: A marginal cost of capital (MCC) schedule is simply a plot of the

firm's WACC versus dollars of new capital raised. The firm's MCC schedule is
shown in the figure below. The plot is called the marginal cost of capital
schedule because it shows the cost of each additional, or marginal, dollar

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 21
raised (the marginal cost).

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SOLUTION TO MINI CASE
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Chapter 6 - 22 Copyright © 1996 by The Dryden Press. All rights reserved.
 As more and
more new
capital is
required in
any year, the
company's WACC
would
eventually
begin to rise
above 10.7
percent. The
company would
have to find
new buyers of
its debt,
preferred, and
common stock,
and those new
buyers would incur credit checking costs and/or require higher rates of return
to be enticed to invest in the firm's securities. Also, particularly large
capital investment programs would probably increase the firm's perceived
riskiness, because investors would become increasingly concerned about
management's ability to manage such rapid growth efficiently. (Note: Most of
the firms with which we have dealt have not attempted to quantify this
increase in the early planning stages, but, rather, they have more or less
arbitrarily raised their WACC if they anticipated that extraordinarily large
amounts of capital might have to be employed.)
The planned use of the funds could affect its cost. In all of the
discussion thus far, we have implicitly assumed that the company would invest
in assets with about the same risk characteristics as the existing assets. If
the company planned to invest in riskier assets, this would raise its cost of
capital, and vice versa. The company would have to state, in any prospectus
issued in connection with raising capital, what it planned to do with the
money.

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SOLUTION TO MINI CASE
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Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 6 - 23
k. We know that a firm's annual cash flows are equal to net income plus
noncash expenses, typically net income plus depreciation, yet the
analysis thus far has ignored the depreciation cash flow. What impact
does depreciation have on Davis's MCC schedule? Would a consideration of
depreciation affect the acceptability of proposed capital budgeting
projects and the size of the total capital budget? Explain.

ANSWER: Depreciation-generated funds are available to invest in new plant and

equipment, to pay dividends, to retire debt or repurchase stock, and so on.
However, depreciation is an allowance for the reduction in value of a firm's
assets through wear-and-tear and obsolescence, and hence it represents a
return of as opposed to on investment, and as such it belongs to all the
investors who supplied the capital in the first place. Since
depreciation-generated funds could, like retained earnings, be distributed to
the capital suppliers (for Davis, its common stockholders, preferred
stockholders, and bondholders) for reinvestment in securities of similar risk,
depreciation-generated funds also have an opportunity cost. However, in this
case the cost is the WACC using retained earnings as the common equity
component, since depreciation funds would be distributed pro rata to all the
capital suppliers. Thus, for Davis, the cost of depreciation-generated funds
is 10.3 percent.
The effect of depreciation is to shift out the first break point in the
MCC schedule from $500,000 to $1 million. Even though the firm may plan to
use its entire $500,000 of depreciation-generated funds for replacing worn-out
and obsolete equipment, those projects must still pass through a capital
budgeting analysis.
The treatment of depreciation definitely could affect capital budgeting
decisions. As we shall see in a later chapter, the MCC schedule has a major
influence on the cost of capital that is used in capital budgeting analysis,
and if the lower cost MCC is pushed out to the right, the cost of capital used
to evaluate projects will generally be lower than if depreciation were not
considered when developing the MCC schedule. Since a reduction in the cost of
capital could lead to the acceptance of more individual projects, and, hence,
to a larger total capital budget, the treatment of depreciation is quite
important.

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SOLUTION TO MINI CASE
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Chapter 6 - 24 Copyright © 1996 by The Dryden Press. All rights reserved.